CFA Level 3 Asset Allocation

describe the use of the global market portfolio as a baseline portfolio in asset allocation; (Asset All.) 5h

- Global market portfolio contains all available risky assets in proportion to the market values - GMP minimizes non-diversifiable risk and therefore makes the most efficient use of the risk budget - Provides a reference point for a highly diversified portfolio (investor must provide justification for moving away from global market cap weights) - Provides discipline in mitigating home country bias Implementation hurdles - Estimating the size of each asset class on a global basis is an imprecise exercise given the uneven availability - Real Estate and PE are not easily carved into pieces of a size that is accessible to most investors - The practicality of investing proportionately in residential real estate, which is held in homeowners hands, has been questioned

discuss the use of Monte Carlo simulation and scenario analysis to evaluate the robustness of an asset allocation; (Asset All.) 6g

- Monte Carlo can be used to better illustrate to clients the range of possible outcomes that they can expect - Addresses the limits of MVO as a single period model and the issues of rebalancing and taxes - Formulating the multi-period problem mathematically would be a daunting challenge. We could more easily incorporate the interaction between rebalancing and taxes in a MC simulation - The need for MC simulation in evaluating an asset allocation depends on whether there are cashflows in or out. When terminal wealth is path dependent (the sequence of returns matter), an analytical approach is not feasible but MC simulation is balancing and taxes

explain the use of risk factors in asset allocation and their relation to traditional asset class-based approaches; (Asset All.) 5f

- Risk factors include: liquidity, volatility, interest rate duration, foreign exchange, default risk - Risk factors can overlap between multiple asset classes (Examining the overlapping characteristics can help individuals identify correlations) - Sources of risk for more broadly defined asset classes are generally better distinguished than those for narrowly defined groups (US equity would be broad, SC/ LC would be more narrow) Factor based approaches - do not use asset class as the basis for portfolio construction - Focus on assigning investments to the investor's desired exposures to specified risks - Asset classes can be described by their sensitivities to each factor

describe how client needs and preferences regarding investment risks can be incorporated into asset allocation; (Asset All.) 6f

- Utilize Monte Carlo Scenario to help show the various outcomes - Add additional constraints such as limitations to risky assets - Specify a risk aversion factor

describe the use of investment factors in constructing and analyzing an asset allocation; (Asset All.) 6h

A factor based approach for liability relative asset allocation has gained interest and credibility for several reasons - In many application the liability cash flows are dependent on multiple uncertainties. The two primary macro factors are future economic conditions and inflation - A fully hedged portfolio cannot be constructed while liabilities are impacted by these uncertain factors In addition to the all important market (equity) exposure, typical factors used in asset allocation include - Size - Valuation - Momentum - Liquidity - Duration (term) - Credit - Volatility These factors represent what is referred to as a zero (dollar) investment, or self-financing investment in which the underperforming attribute is sold short to finance an offsetting long position

recommend and justify an asset allocation using a goals-based approach; (Asset All.) 6m

A goals based asset allocation process disaggregates the investor's portfolio into a number of sub portfolios, each of which is designed to fund an individual goal. The goals-based approach to asset allocation is useful for individual investors, who typically have a number of (sometimes conflicting) objectives, with different time horizons and different levels of urgency, which we will measure as specified required probabilities of success. Individuals have needs that are different from those of institutions. The most important difference is that individuals have multiple goals each with its own time horizon and urgency Ways of Defining Goals Institutions - Goals (Single) - Time Horizon (single) - Risk measure (volatility (return or surplus) - Return determination - Mathematical expectations - Risk determination - top-down/ bottom up - Tax status - single often tax exempt Individuals - Goals (Multiple) - Time Horizon (Multiple) - Risk measure (probability of missing goal) - Return determination - minimum expectations - Risk determination - bottom up - Tax status - mostly taxable Characteristics of individuals goals have three major implications: - Overall portfolio needs to be divided into sub-portfolios to permit each goal to be addressed individually - Both taxable and tax exempt are important - Minimum expectations replace the typical mathematical expected average Having defined the needs of the investor in as much detail as possible, the next step in the process is to identify the amount of money that needs to be allocated to each goal. (You'll be given tables with required success and minimum expected returns and have to choose the optimal one) - then you will have to discount back the cash needed, by the discount rate and time horizon - This usually fills all of the cash needed for liabilities and leaves an amount in surplus as well Once set the goals based allocation must be regularly viewed. Two considerations dominate: - Goals with an initially fixed time horizon are not necessarily one year closer to maturity after a year. Experience suggests that certain horizons are placeholders - The preference for upward rather than downward volatility, combined with perception that goals may have higher probabilities than is truly the case, leads to portfolios that outperform the discount rate

describe and evaluate heuristic and other approaches to asset allocation; (Asset All.) 6n

Additional models that don't require sophisticated math 120 - your age, - this would be the percentage that you should have in equities - Has a close fit to general glide path for target date funds 60/40 - split just keep it in a simple equity/ bond split Yale Model/ Endowment Model - allocate larger portions to the alternatives than is normally considered 1/N rule - allocating equally across asset classes - By treating all assets as indistinguishable in terms of mean returns, volatility and correlations, in principle, 1/N portfolios should be dominated by methods that optimize asset class weights to exploit differences in investment characteristics Risk Parity - The idea with the risk parity asset allocation approach is that diversification is achieved by ensuring that each asset class contributes the same amount to the total portfolio risk. This addresses critique 4 of MVO that diversification across asset classes does not guarantee diversification across risk sources. The criticism of this approach is that it ignores expected returns and focuses only on risk. - Weight of asset i x covariance of asset i with the portfolio = 1/n x variance of the portfolio - After deriving a risk parity based asset allocation the next step is to borrow (use leverage) or to lend (save a portion of wealth, presumably in cash) so that the overall portfolio corresponds to the investors risk appetite

discuss factors affecting rebalancing policy (Asset All.) 6o

An appropriate rebalancing policy involves a weighing of benefits and costs. Disciplined rebalancing has tended to reduce risk while incrementally adding to returns. Several interpretations have been offered. - Rebalancing earns a diversification return (going back to a well-diversified portfolio earns the return, i.e. if the SAA is optimal then departures must be sub-optimal) - Rebalancing earns a return from being short volatility Factors affecting the optimal corridor width of an asset class - Transaction costs (higher means a wider optimal corridor) - Risk Tolerance (High risk tolerance, wider the optimal corridor) - Correlation (higher correlation with portfolio, wider the corridor) - Volatility (higher volatility, narrower the corridor) Tax considerations in rebalancing: - Frequent rebalancing exposes taxable asset owner to realized taxes that could have been deferred - Must consider the trade off between benefits tax minimization, merits of maintaining the targeted SAA - Rebalancing ranges for a taxable portfolio can be wider than those of a tax-exempt portfolio with a similar risk profile - Strategies to reduce tax impact (tax loss harvesting, tax location (place less tax efficient assets in accounts with favorable tax treatment

contrast concepts of risk relevant to asset-only, liability-relative, and goals based asset allocation approaches; (Asset All.)5d

Asset Only - This focuses mainly on asset class risk - This can mainly be judged by standard deviation, downside (Semi variance and VaR) and tail risk (MVO) Liability Relative - The main risk deal with not having enough money to pay for liabilities when they come due (Shortfall risk) - Standard deviation of surplus may be used as a risk measure; - Volatility of contributions needed to fund liabilities Goals Based - Risk of failing to achieve goals - Limits can be quantified as the maximum acceptable probability of not achieving a goal, - overall portfolio risk is the weighted sum of risks associated with each goal

discuss asset size, liquidity needs, time horizon, and regulatory or other considerations as constraints on asset allocation (Asset All.) 7a

Asset Size May limit the opportunity set by virtue of: - Scale needed to invest successfully in certain asset classes - The availability of investment vehicles necessary to implement the asset allocation Too small AUM - may not have sufficient governance capacity to develop the required knowledge base for complex asset classes Too large AUM - desired minimum investment may exhaust the capacity of active external managers in certain asset classes Size Constraints - Cash (No size constraints) - Equities - passive no size constraint; Large Cap developed market equity/ SC/ EM equity (generally accessible to large and small asset owners, although the very large asset owners may be constrained in the amount of assets allocated to certain active strategies) - Bonds (Accessible to large and small, but smaller asset owners may need to implement via a commingled vehicle) - Alternative Investments (There may be legal minimum qualifications that exclude smaller asset owners) Liquidity needs Some owners require lots of liquidity while others don't as much - Bank- high need for liquidity for day to day operations - Endowments, Pension Plans, Sovereign Wealth Fund - longer horizon lower liquidity needs, can exploit liquidity premiums available in such asset classes as private equity, RE, etc. - A family with several children nearing college-age will have higher liquidity needs than a couple of the same age with not children - An insurance company who is predominantly life or auto where losses are predictable can absorb more risk than property/ casualty whose losses are subject to unpredictable events like natural disasters Time Horizon - The changing composition of the asset owner's assets and liabilities must also be considered. - As time progresses the character of both assets (human capital) and liabilities changes - As the employee base ages and prospective retirements are not so far in the future, the liability is more comparable to intermediate or even ST bonds Regulatory and other External Constraints Insurance Companies - Insurers are most often highly focused on matching assets to the projected, probabilistic cash flows of the risk they are underwriting - Allocations to certain asset classes are often constrained by a regulator i.e. max amount in equity. - Insurance regulators generally set a minimum capital level for each insurer based on that insurer's mix of asset, liabilities and risk Pension Funds - Some countries regulate maximum or minimum percentages in certain asset classes - Pension funds are also subject to a wide array of funding, accounting, reporting and tax constraints that may influence asset allocation decisions Endowments and Foundations - Endowments and foundations are often established with the expectation that they will exist in perpetuity and thus can invest with a long term investment horizon - One potential constraint is that in order to maintain tax statutes they may have to distribute a minimal amount every year - Another is that endowment and foundation assets are often used to support the BS, and lenders may require minimum BS ratios. AA has to consider risks of affecting the BS. Sovereign wealth Funds - May have minimum investment requirements in Social or ethical investments; also may prohibit investments in things like alcohol, tobacco, firearms - May have a maximum amount allowed for alternatives - These are also managed for the people, so they are subject to scrutiny by the citizens

compare the investment objectives of asset-only, liability-relative, and goals based asset allocation approaches; (Asset All.) 5c

Asset only - Asset allocation decisions are made based solely on the assets; liabilities are not explicitly modeled (MVO is the most familiar and studied AO model); - The objective is to maximize Sharpe Ratio for acceptable level of volatility Liability- relative - The objective is mainly paying liabilities when they come due and invest excess for growth - Focus is on surplus i.e. have a positive value for assets minus the PV of liabilities - Typically used by banks/ DB plans/ insurers - Objective: fund liabilities and invest excess for growth Goals Based - Used primarily for individuals and families, including specifying probabilities for sub portfolios - Each goal is associated with a risk tolerance, time horizon, and with specified required probabilities of success - Objective: achieve goals with specified required probability of success

recommend and justify revisions to an asset allocation given change(s) in investment objectives and/or constraints (Asset All.) 7c

Based on the level of funding or the state of the economy plans may have to shift their goals Change in Goals - Change in business conditions affecting the organization supporting the fund and therefore expected changes in cash flows - A change in the investor's personal circumstances that may alter her appetite or risk capacity (marriage, children i.e.) Change in constraints that necessitate a change in the plan include - Liquidity - i..e significant expected payments from the fund - A significant cash inflow or unanticipated expenditure - Regulations - i.e. governing donations or contributions to the fund - Time horizon - i.e. resulting from the adoption of a lump sum distribution option - Asset size - as a result of merging of pension plans Beliefs - Change in market conditions could cause the plan to make a change - An integral aspect of any asset allocation exercise is the forecasting of expected returns, volatilities and correlations. A material change in the outlook for one or more of the asset classes may heavily influence the asset allocation outcome

interpret and evaluate an asset allocation in relation to an investor's economic balance sheet; (Asset All.) 6c

By including something like human capital, the ability of the individual to take risks increases - You can model human capital with inflation securities and corporate bonds Residential real estate can be treated in a similar manner - This can be modeled based on a residential property index Depending on the nature of an individual's career, human capital can provide relatively stable bond like cash flows. At the other extreme, cash flows from HC can be much more volatile from a seasonal business. If the HC is stable this increases the individuals capacity to take risk

formulate an economic balance sheet for a client and interpret its implications for asset allocation; (Asset All.) 5b

Economic balance sheet functions like a normal financial balance sheet only you have extended assets and liabilities that wouldn't normally be included known as extended portfolio assets and liabilities. Extended portfolio assets include: - PV of earnings (human capital) - PV of pension payout - PV of inheritances - PV of consumption (liability) As the individual progresses through life the present value of human capital decreases as human capital is transformed into earnings. Earnings saved and invested build financial capital balances. By retirement age the conversion of human capital to earnings and financial capital is assumed to be complete.

describe elements of effective investment governance and investment governance considerations in asset allocation; (Asset All.) 5a

Governance Structure: - Governing investment committee - Investment staff - Third party resources - i.e. investment managers, consultants Most effective governance models share six common elements: 1. Articulate the long and short-term objective of the investment program (typically a return objective, meet some future obligation/ liability, must also consider liquidity and risk requirements) 2. Allocate decision rights and responsibilities among the functional units in the governance hierarchy effectively (delegation should be to those best qualified to make informed decision) 3. Specify the process for developing and approving the investment policy statement (the IPS is a foundation document that is revised slowly, whereas information relating to more variable aspects - asset allocation policy - will be in the appendix) 4. Specify processes for developing and approving the strategic asset allocation (investment committee typically retains approval of the SAA decision) 5. Establish a reporting framework to monitor the program's progress toward the agreed-on goals and objectives (Key elements: benchmarking is necessary for performance measurement, attribution and evaluation) 6. Periodically undertake a governance audit (the purpose of the governance audit is to ensure that the established policies, procedures, and governance structures are effective. Good governance seeks to avoid decision-reversal risk - the risk of reversing a chosen course at exactly the wrong time)udit

discuss asset class liquidity considerations in asset allocation; (Asset All.) 6d

Less liquid asset classes such as real estate and private equity require a liquidity return premium to compensate the investor for the liquidity risk - These asset classes are difficult to include because there are few indexes to track them, thus it is more challenging to make capital market expectations - Even when indices exist they are typically not investable - Due to the illiquid nature it is widely believed that the indexes don't accurately reflect their true volatility In addressing asset allocation involving less liquid asset classes, practical options include the following: - Exclude these asset classes when running an MVO - Include less liquid asset classes in the AA decisions and attempt to model the inputs to represent the specific risk characteristics associated with the likely implementation vehicles - Include less liquid asset classes in the AA decisions and attempt to model the inputs to represent the highly diversified characteristics associated with the true asset classes - Cash (no size constraints) - Equities (passive no size constraints), very large asset owners may be constrained with certain active strategies/ managers - Real Estate - smaller asset owners may need to consider co-mingled funds for diversification - Alt. Investments (may be legal minimums that excludes small owners), there is a level of investment understanding required and minimum investments favor larger asset owners

identify behavioral biases that arise in asset allocation and recommend methods to overcome them; (Asset All.) 7e

Loss aversion bias - when investors dislike losses more than they like gains - Goals based investing can help offset this, as in goals investing higher priority goals are given lower risk - By segregating into sub-portfolios aligned to goals designed by the client as high priority and investing in risk free or low risk assets, the advisor mitigates loss aversion bias with that goal Illusion of control, tendency to estimate the control of events - May lead to too frequent trading - Too much leverage - Retaining a large, concentrated legacy asset that contributes diversifiable risk - Alpha seeking behaviors such as market timing in the form of all in or all out market calls - To counter this the market portfolio from CAPM should be used as the starting point in developing asset allocations Mental accounting - Information processing bias in which people treat one sum of money differently than another based on the mental account. - The concentrated stock/ mental accounting bias can be accommodated in goals-based asset allocation by assigning the concentrated position to an aspirational goal. Representative Bias - the tendency to overweight the importance of the most recent observations. - The strongest defenses against recency bias are an objective asset allocation process and a strong governance framework. It is important that the investor objectively evaluate the motivation underlying the response to recent market events - A formal asset allocation with pre-specified allowable ranges will constrain representativeness bias Framing Bias - Bias in which a person may answer a question differently based solely on the way in which it is asked - The framing effect can be mitigated by presenting the possible asset allocation choices with multiple perspectives on the risk/ reward trade-off - The most common measure standard deviation can be supplemented with additional measures like shortfall probability Availability bias - focusing on estimating the probability of an outcome based on how easily the outcome comes to mind - Starting with the global market portfolio can help mitigate

describe and evaluate the use of mean-variance optimization in asset allocation; (Asset All.) 6a

Mean variance optimization - provides a framework for determining how much to allocate to each asset in order to maximize the expected return of the portfolio for an expected level of risk - MVO is a single period framework in which the single period could be a week, month, year, or some other period The objective function is expressed as: Investors Utility = Expected return of the portfolio - .005 x investor's risk aversion coeff. X variance of the portfolio with a given asset allocation - Risk aversion coeff. (0 is risk neutral, 4 is moderately risk averse, 6 would be very risk averse) - Lower risk aversion coefficient leads to a riskier point on the efficient frontier while a higher risk aversion coefficient leads to a more conservative point - This equation involves estimating the investor's risk aversion parameter and then finding the efficient portfolio that maximizes expected utility The inputs for MVO are - expected return, - standard deviation, and - correlations between the between the asset classes Constraints: weights must sum to 1 Only positive weights allowed Problems with MVO - The outputs (asset allocation) are highly sensitive to small changes in the inputs, so if you have poor inputs you can't expect fair results - The asset allocations tend to be highly concentrated in a subset of the available asset classes. This leads to lack of diversification -Many investors are concerned about more than the mean and variance of returns, the focus of MVO, they may be concerned about skewness and kurtosis (Tools developed to address include mean-semivariance optimization, mean-variance skewness optimization, mean conditional VaR optimization) - While MVO can diversify across asset classes, some asset classes will share similar risks so those can't be diversified away (Remedy: use factor based allocation) - Most portfolios exist to pay for a liability or consumption series, and MVO allocations are not directly connected to what influences the value of the liability or the consumption series (Remedy: Liability Relative or goals based allocation) - MVO is a single period framework that does not take account of trading/ rebalancing costs and taxes (Remedy: Use Simulations) Problems 1 and 2 are solved by reverse optimization or Black Litterman

discuss strategic considerations in rebalancing asset allocations (Asset All.) 5j

Rebalancing is the discipline of adjusting portfolio weights to more closely align with the strategic asset allocation. Because rebalancing is countercyclical it is fundamentally a contrarian investment approach There are many different rebalancing approaches Calendar rebalancing - rebalance at a certain time every month/ year - Although simple, rebalancing points are arbitrary and have other disadvantages Percentage range rebalancing - tolerance bands are set - This minimizes the amount that the portfolio will sway from its original position but it could potentially also cost more through more trading Three places to rebalance back to: - Back to target weights - Rebalance to range end - ½ way between range end and target weight Optimal width of the corridor for an asset class depends on the following - Transaction costs - the more expensive it is to trade, the less frequently you should trade and the wider rebalancing ranges - Risk tolerance - more risk averse people will have tighter bands - Correlations - The more correlated assets are the less you will have to rebalance; i.e. wider rebalancing ranges; less correlated have tighter rebalancing ranges - Liquidity - illiquid investments are usually associated with higher trading costs. The liquidity costs encourage the use of wider rebalancing corridors - Taxes - taxable portfolios will want to have wider bands than nontaxable ones - Belief in momentum, wider trading ranges, belief in mean reversion narrower

describe and evaluate the use of mean-variance optimization in asset allocation; (Asset All.) 6a (Resampled Eff, BL, MC)

Reverse Optimization takes as its inputs a set of asset allocation weights that are assumed to be optimal and, with the additional inputs of covariances and the risk aversion coefficient, solves for expected returns. These reverse- optimized returns are sometimes referred to as implied or imputed returns. - The most common set of starting weights is the observed market capitalization value of the assets or asset classes that form the opportunity set - However, reverse optimization can work with any set of starting weights - If one has strong views on expected returns that differ from the reverse-optimized returns, an alternative or additional approach is needed - Helps solve the MVO problems of concentrated positions and sensitivity to small difference in inputs. Black Litterman Model - is a complementary addition to reverse optimization - Starts with excess returns produced from reverse optimization and then provides a technique for altering reverse optimized expected returns - allows for the investor's own distinctive views on the implied returns from those produced by reverse optimization. analyst adjusts the output from reverse optimization with his expectations of the market before he continues to retrieve asset weights. - BL has two methods for showing viewpoints: one in which the absolute return forecast is associated with a given asset class, and one in which the return differential relative to another asset is expressed (i.e. Japan will outperform UK by 100 bps - Can add constraints beyond the budget constraint (i.e. upper limit to an asset class, allocation range for an asset) - Helps solve the MVO problems of concentrated positions and sensitivity to small difference in inputs. Resampled Mean Variance Optimization - combines the mean variance optimization framework with Monte Carlo simulation and leads to more-diversified asset allocations - Resampling uses MC simulation to estimate a large number of potential capital market assumptions for MVO and the resampled frontier - Resulting asset allocations are averaged

recommend and justify an asset allocation based on an investor's objectives and constraints; (Asset All.)5g

Strategic asset allocation combines market expectations with investor's tolerances Selection of a strategic asset allocation generally involves the following steps: - Determine and quantify the investor's objectives - Determine Risk Tolerance and how risk should be expressed and measured - Determine Time Horizon - Determine Constraints (Tax social, governmental) - Determine approach to asset allocation most suitable for investors (i.e. asset only, liability relative, goals based) - Select asset classes and asset allocation - Develop a range of potential asset allocation choices - Simulate results Gives an example of a Pension Fund with a 1.08 funded ratio and you have to choose between Asset Only and Liability relative - Asset Only would be 65 stocks / 35 bonds (creates contribution risk for the plan) - Liability would be 90 bonds (to cover the liabilities)/ 10 stocks (Liabilities are defeased) However, the choice depends on the goal of the plan Goals based approaches generally set the strategic asset allocation in a bottom up fashion. Two classification systems for goals have been proposed: Brunel (2012) - Personal goals - to meet current lifestyle requirements and unanticipated financial needs - Dynastic goals - to meet descendants needs - Philanthropic goals Chhabra (2005) - Personal risk bucket - to provide protection from a dramatic decrease in lifestyle - Market risk bucket - to ensure the current lifestyle can be maintained (allocations for average risk adjusted market returns) - Aspirational bucket - increase wealth substantially (greater than average risk is accepted)

discuss the use of short-term shifts in asset allocation; (Asset All.) 7d

Tactical Allocations are used to take advantage of short term market shifts - ST shifts could be caused by business or monetary cycle opportunities or temporary price dislocations - Objective: increase risk-adjusted returns by taking advantage of ST market conditions - Tactical investment decisions may incur additional costs (trading and taxes), and can also increase the concentration of risk relative to the policy portfolio Strategic Asset Allocation focuses on the longer term plan - This is the benchmark against which TAA is measured How can you measure the Tactical Asset Allocation vs. Strategic - Sharpe Ratio vs. policy portfolio - Information ratio vs. policy portfolio - Plotting the realized return and risk of the TAA portfolio versus the realized return and risk of portfolios along the SAA's efficient frontier Discretionary TAA is typically used in an attempt to mitigate or hedge risk in distressed markets while enhancing returns in positive return markets. When utilizing a discretionary tactical allocation there are a lot of metrics a manager may look at to take advantage - P/E, P/B, dividend yield - Margin borrowing - people buying on margin is a bullish indicator - Short interest - higher short interest would be a negative indicator Systematic TAA attempts to capture asset class level return anomalies that have been shown to have some predictability and persistence. - Based on technical analysis/ market signals - Value and momentum are factor that have been determined to offer some level of predictability both among securities within asset classes and at the asset class level.

discuss strategic implementation choices in asset allocation, including passive/ active choices and vehicles for implementing passive and active mandates; (Asset All.) 5i

Tactical asset allocation - (TAA) is an active management strategy that deviates from the strategic asset allocation (SAA) to take advantage of perceived short-term opportunities in the market. TAA introduces additional risk, seeking incremental return, often called alpha. - Key barriers to successful tactical asset allocation are monitoring and trading costs. For some investors higher short term capital gains taxes will prove a significant obstacle. Dynamic asset allocation recognizes that the performance in one period affects the performance in the next. - A multiperiod view of the investment horizon, DAA recognizes that asset (and liability) performance in one period affects the required rate of return and acceptable level of risk for subsequent periods. - Deviations from SAA motivated by longer term valuation signals or economic view. Passive/ Active - With active the portfolio composition changes with investor insights and when expectations change Decisions between passive/ active depends on: - Availability of investments - Active management ability to scale - Ability to be passive with client constraints i.e. ESG - Belief in efficient markets (a strong belief in market efficiency for the asset class would orient the investor away from active) - Tax status of investors (taxable investors would tend to have higher hurdles to profitable active management than tax exempt investors) - Cost benefit tradeoff, of the increased transactions from being active, investment management costs etc. Risk budgeting addresses the questions of which types of risks to take and how much of each to take. - Active risk budgeting addresses the question of how much benchmark-relative risk an investor is willing to take in seeking to outperform a benchmark

discuss tax considerations in asset allocation and rebalancing (Asset All.) 7b

Taxable entities should consider the after tax characteristics when making investments - Least tax efficient investments should be placed in the most tax advantaged accounts - Dividends and capital gains are usually taxed at a lower rate than interest - Generally interest income incurs the highest tax rate - After tax return = return (Pre-tax) (1 - t) - After tax standard dev. = st. dev. (Pre-tax) (1 - t) Portfolio rebalancing - Rebalancing should occur less frequently in taxable portfolios, due to the reduction in volatility caused by taxation - Taxable portfolios will realize gains at each rebalance so you should look for offsets to balance the gains and avoid taxes - After tax rebalancing range = Pre-tax rebalancing range / (1- tax rate) Strategies to reduce tax impact: - Tax loss harvesting (Deliberately realizing losses to offset gains) - Strategic asset allocations (Deliberately finding the most efficient use of tax advantaged accounts) - One important exception is for assets held for near -term liquidity needs. Because tax exempt and tax-deferred accounts may not immediately be accessible, a portion may be held in taxable accounts

describe and evaluate the use of mean-variance optimization in asset allocation; (Asset All.) 6a (More MVO)

The asset allocation mix - The asset allocation weights for the reverse optimization method are inputs into the optimization and are determined by the market capitalization weights of the global market portfolio. - The asset allocation weights for the MVO method are outputs of the optimization with the expected returns, covariances, and a risk aversion coefficient used as inputs. - The two methods result in significantly different asset allocation mixes. - In contrast, the outputs of an MVO are the asset allocation weights, which are based on (1) expected returns and covariances that are forecasted using historical data and (2) a risk aversion coefficient - The values of the expected returns for MVO and Reverse Optimization - For the reverse optimization approach, the expected returns of asset classes are the outputs of optimization with the market capitalization weights, covariances, and the risk aversion coefficient used as inputs. - In contrast, for the MVO approach, the expected returns of asset classes are inputs to the optimization, with the expected returns generally estimated using historical data. - The computed values for the expected returns can be calculated via CAPM i.e. market risk premium * Beta + RFR. - The output of the reverse optimization method are optimized returns which are viewed as unobserved equilibrium or imputed returns. The equilibrium returns are essentially long-run capital market returns provided by each asset class and are strongly linked to CAPM. In contrast, the expected returns in the MVO approach are generally forecasted based on historical data and are used as inputs along with covariances and the risk aversion coefficient in the optimization. The reverse-optimized returns are calculated using a CAPM approach.

explain how asset classes are used to represent exposures to systematic risk and discuss criteria for asset class specification; (Asset All.) 5e

The following criteria can be used to specify asset classes - Homogenous - Assets within a class should have similar attributes - Mutually exclusive - Assets cannot be classified into more than one class - Diversifying- Asset classes should not be highly correlated between themselves, as this would duplicate risk exposures already present - Investable: asset classes as a group should make up a preponderance of world investable wealth - Liquidity: Asset classes selected for investment should have the capacity to absorb a meaningful proportion of an investor's portfolio. If liquidity and transaction costs are unfavorable, the class may not be practically suitable for investment Well accepted asset classes include: - Global equity - Global Private Equity - Global Fixed Income - Real Estate Super asset classes - Capital assets - ongoing source of something of value (such as interest or dividends) - Consumable/ transformable assets - Assets, such as commodities, that can be consumed or transformed - Store of value assets - Neither income generating nor value as a consumable, examples include currencies, gold , art

discuss approaches to liability-relative asset allocation; (Asset All.) 6k

There are three approaches to liability relative asset allocation Surplus Optimization - Surplus optimization involves adapting asset-only mean-variance optimization by substituting surplus return for asset return over any given time horizon. - Optimize over all assets and liabilities (liabilities are included as negative assets) - Surplus optimization links assets and the pv of liabilities through a correlation coefficient, the two portfolio model doesn't - Surplus objective function = Expected surplus return - .005 x risk aversion x standard deviation squared The steps to the surplus optimization approach are: - Select asset categories and determine the planning horizon - Estimate expected returns and volatilities - Determine any constraints - Estimate the expanded correlation matrix - Compute the surplus efficient frontier and compare it with the AO efficient frontier (differences in asset allocations are most significant in conservative portfolios, Risky Surplus Optimization and AO portfolios are similar) - Select a recommended portfolio mix Hedging/ Return Seeking Approach - Create one portfolio that is strictly for hedging, and use the remainder to be managed independently with a return seeking portfolio though MVO or another method - The hedging portfolio can be created using the various techniques such as cash flow matching, duration matching, and immunization. - This approach is often used for insurance or overfunded pension plans that wish to reduce or eliminate the risk of not being able to pay future liabilities - It can be modified to hedge only partially, or increase amount to hedging portfolio as the funding ratio and surplus increase Hedging Portfolio - Must include assets whose returns are driven by the same factors that drive the returns of the liabilities. Even if the assets and liabilities start with equal values they will be inconsistent over time There are two limitations of this approach: · If the funding ratio is less than one, it's difficult to create a hedging portfolio that completely hedges the liabilities, unless there is a sufficiently large positive cashflow (contribution) · A hedging portfolio may not be available to hedge certain kinds of risk, i.e. weather related causes such as hurricanes or earthquakes. The investor has basis risk when imperfect hedges are employed. Compare how surplus optimization and hedging/ return seeking portfolio approach take account of liabilities - Surplus optimization approach links assets and the PV of liabilities through a correlation coefficient. The two portfolio model does not require this. SO considers the AA problem in one step, the H/RS approach divides it into two - When the plan is conservative and underfunded, the SO and hedging portfolio will have basically the same allocation Integrated Asset Liability approach - This is used when decisions regarding the composition of liabilities must be made in conjunction with the asset allocation decision - Some places already have liabilities in place while others like banks, L/S hedge funds, get to make decisions about their liabilities jointly when setting their allocation model - This is called an integrated asset liability approach - Decisions about the AA will affect the amount of business available (i.e. loans a bank can make

explain absolute and relative risk budgets and their use in determining and implementing an asset allocation; (Asset All.) 6e

There are three aspects to risk budgeting - The risk budget identifies the total amount of risk and allocates the risk to a portfolio's constituent parts - An optimal risk budget allocates risk efficiently - The process of finding the optimal risk budget is risk budgeting MCTR/ ACTR - MCTR - marginal contribution to total risk ( identifies the rate at which risk would change with a small change in the current weights) - MCTR = (Asset Class Beta) * (Portfolio Return standard deviation) - ACTR - absolute contribution to risk (measures how much the asset class contributes to the portfolio volatility) - ACTR = weight x MCTR - % of risk contributed by position = ACTR/ total portfolio risk An allocation is optimal when Expected return - risk free rate / MCTR is the same for all assets and matches the Sharpe ratio of the total portfolio

recommend and justify an asset allocation based on the global market portfolio; (Asset All.) 6i

This is where they will give you sample portfolios and you will have to find the one that best fits

describe and evaluate characteristics of liabilities that are relevant to asset allocation; (Asset All.) 6j

True risk of liability driven portfolio is that the portfolio won't pay for the liability Characteristics of Liabilities that can affect Asset Allocation - Fixed vs. contingent (timing and amount depends on some future event) cash flows - Legal (contractual) vs. quasi liabilities (Cash payments expected to be made but are not liabilities) - Duration and convexity - i.e. the change in values of a liability given a change in interest rates - Value of liabilities compared with the sponsoring org (If the liability is small compared to the size it might not be as big a deal) - Timing considerations such as Longevity Risk - Regulations around the liabilities value particularly in the insurance industry - Factors driving future liability cash flows (inflation, interest rates, risk premium)

recommend and justify a liability-relative asset allocation; (Asset All.) 6l

Two portfolio - This approach is most often used for insurance companies and overfunded pension plans that want to minimize the risk of underfunding. Surplus optimization: This is an extension of MVO in which we determine an efficient frontier based on the surplus with its volatility as our measure of risk, stated either in money or percentage terms. A-L Approach - Banks, hedge funds with short positions, and insurance companies, however, make decisions about the composition of their liabilities jointly with their asset allocation decisions. There is a continuous feedback loop between the two, which requires a multiperiod model. This is often referred to as an integrated asset-liability approach. Characteristics of Surplus Optimization vs. Hedging/ Return seeking vs. Integrated AL Surplus Optimization - Less complex - Incorporates all levels of risk - Can use any funded ratio - Uses single period framework AL - - most complex (it requires a formal method for selecting liabilities and for linking the asset performance with changes in liability values) - incorporates all levels of risk, - can use any funded ratio, - and allows for multiple periods H/RS - less complex, - Good for investors with low levels of risk, - needs positive funded ratio for basic approach, - single periods

recommend and justify an asset allocation using mean-variance optimization; (Asset All.) 6b

You can utilize the investors utility equation which is expected return - .005 x investors risk aversion (Lambda where higher is more risk averse) x variance (standard Dev. Squared) of portfolio with a given AA You could also use Roy's Safety First Criteria which is - Expected Return - minimum needed return / standard deviation Also you can use the Sharpe ratio - Expected Return - rfr / standard deviation You can also combine the risk free rate with a corner portfolio to get a desired return. I.e. if the desired return is 6.5% and the highest sharpe portfolio is 7.24%, with the rfr yielding 2.2%, you could make a portfolio that's 14.7% rfr and 85.3% of the highest sharpe